The Story of Inflation

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THE STORY

OF

INFLATION

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1

Inflation is very unpopular.

The words general price level" in the definition are very important. They mean that
the term "inflation' applies only to a rise in the average cost of all the things
we buy. and not to an increase in the price of only one item or class of items

Of course, a large Increase in the price of one item can sometimes lead to rapid inflation - that is to a

rapid increase in the general price level. For example, a very rapid nse of oil pnces could lead to a rise

in the general price level, because oil plays a key role throughout our economy.

What's wrong with inflation anyway? After aU, if prices

go up, people who sell things wi!l receive more dollars

than they did tiefore. That means that incomes go up too.

Whafs wrong with thatf

One answer is that not everyone's income goes up as

much as prices do. People whose incomes rise less than

prices - or don't rise at all - are hurt by inflation.

They are unable to buy all the things they used to

with their income.

Among those hurt by inflation are fenders who charge
<nterest rates that are lower than the rate of inflation.

For example, suppose someone extends a one-year

loan at an interest rate of 5* and then prices go up lOS

during the year. The lender will be repaid witn money

that has less purchasing power that did the money he

parted with a year earlier.

Many retired people are hurt by Inflation because their
pensions don't keep up with increases in the price level.

Inflation also reduces the value

of people's savings when price

increases are lafger than the interest

rates ttiat people receive on

their savings accounts.

Because inflation reduces the value of savings, it gives
people an incentive to spend rather than save.

Bv discouraaina saving, inflation can harm the U.S. economy. That s because the economy

needs a supply of savings to provide the funds for people and businesses to borrow so that

they can invest in the things that help the U.S- economy grow.

Inflation can hurt, too, by giving people an incentive to
invest in ways that don't help the economy grow.

To enable people to protect the purchasing

power of their savings, the federal

government began issuing inflation -indexed

bonds in 1 997, These bonds allow people to

lend to the government and then be

repaid an amount that will rise in relation

to how much prices rise.

inflation has other undesirable effects. Increases
in prices make it more difficult for businesses to plan.

With (umber prices going up so

fast, I'm trying to stock up before the

next price increase. Meanwhile, I'm

worried that in order to cover my

J, costs, I'll have to charge such high prices

for my houses that nobody will

want to buy Ihcm.

Inflation feeds on itself. When a flour mill has to pay

higher prices for wheat, for example, it has to charge

higher prices for the flour it sells. The bakeries that buy

the flour then have to charge higher prices for the bread

and cakes they sell.

/^ I have to charge you
/ more dough for the bread
I because I have to pay a
\higher price for flour.

The process can easily become a

vicious cycle, because when worl(ers

see the prices they pay going up,

they'll push for higher pay, and if

their employers raise their pay,

they'll have to raise prices to cover

the increased expense. Some

people call this process the

"wage -price spiral."

AS an "inflationary psychology" sets in, people may try to bea' anticipated

price increases by buying more of certain items than they need, and they

may buy other items before they need them.

When people realize they have overbought,

they will cut back on their spending, and the

result can l>e a recession, a downturn in

economic activity that brings a decline in

production and an increase in unemployment.

In fact, since World War II, most recessions have followed
a sustained increase in ttie core rate of inflation.

Core inflation refers to increases in ttie general price
level, excluding food and energy prices. Those prices

are excluded because they are influenced by

special - and temporary - factors, such as weather

conditions or production decisions made by

oil-exporting countries, so they may present a misleading

picture of continuing price pressures in the economy

A very notable episode of tiy per inflation

occurred in Germany in the 1920s and led

to great social unrest in that country. In

the German hyperinflation, the real

purchasing power of money fell so low

that the German currency, the mark,

became a cheaper fuel ttian firewood.

We have seen that inflation can

cause uncertainty and economic

and social instability. But what

causes inflation?

The answer is that inflation results

when there is too much money and

credit around in relation to the

amount of goods and services. By
"money,' we mean cash In circulation

and the amounts that people and

businesses have in bank accounts.

-Credit" refers to the amounts that

baniis and other lenders have lent or

have available to lend.

It's the job of the Federal Reserve System

(known familiarly as "the Fed") to make sure

that money and credit don't grow too rapidly

and lead to inflation.

The Fed s job of mf luendng money and credit conditions in ttie

economy often is a balancing act. If money and credit crow too

rapidly, inflation can result. If they grow too slowly, the result

can be a recession.

J^h'lT.hi^T,? ^I^'rh'^f"'* ^'"r"" ""ff^e a recession because people and uu.i,v,..e.
won t be able to get the loans they need for major purchases at affordable interest rates.

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The Fed has three main monetary policy tools:
reserve requirements, the discount rate and open market operations.

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DISCOUNT RATE

fS^REQUmiMQ!!^

MONEY

ANB

CREDIT

CONDITIOHS

Rp«.rvP renuirements are the proportions of deposits that banks must keep either in their own vault or on deposit

^fh^he Fed («tua ly %«rve r^ulremen^ a'^ly not only to banks but also to other tVP^s onnst,tu Ions that

accept deposits - credit unions, for example, in this case, though, well use the term banks. ]

For ewmole if the reserve requirement is 10%, a bank that receives a SlOO checking
account deS must k^pSIO, either in its own vault or on deposit at the Federal Reserve-

11

In practice, the Fed does not change reserve

requirements very often. In 2008. for example

the reserve requirement on checking accounts

had been unchanged at 16S for 14 years

The discount rate Is the Interest rate thai the Fed charges
on short-ierm loans to banks (or any reason.

When the Fed lowers the discount rate, it may be an

indication that ii would like to see an increase

in credit - and in economic activity. When the Fed

raises the discount rate, tt may be issuing a signal that

It want! to 'cool off the economy," because It is

concerned about the threat of inflation.

1 /^ 's

I

I , \ guess the Fed

{ wants to make sure that
inflation doesn't become
a problem

I inflatic

Open market operations are the monetary policy tool that

the Fed uses most often. These operations, which are

carried out by the Federal Reserve Bank of New York on

behalf of the entire Federal Reserve System, consist

of buying or selling U,S, government securities from firms

known as primary dealers.

When the Fed buys government securities, it pays

for them by crediting the account that the primary

dealer's bank has at the Fed. (The bank, in

turn, credits the primary dealer's account. )

When the Fed sells securities, it receives the payment

from the bank of the buyer. That reduces the total

amount of funds that banks can lend.

Because inflation is so hard to stop once

It gels started, the Fed watches for signs

of future Inflation, so that it can keep the

problem contained.

Federal Reserve economists monitor increases in wages, salaries

and benefits paid to workers - which reflect the bargaining power

of employees, rising costs o( medical care and other insurance

and potential demand for goods and services.

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The Fed keeps track of the value of the

U.S. dollar relative to the currencies of major

trading partners. For example, depreciation

in the dollar reiattve to Japan's currency,

the yen, increases the price of everything

imported from Japan.

Similarly, the Fed v^atches data on the use of manufacturtna

capacity. When capacity utilization gets very high, companies

may have to start using less efficient machinery, and that can

lead to cost and price increases.

Fiscal policy, which involves the use of

government spending and taxes, is another

anti-inflation tool, if inflation threatens,

the government can cut Its spending and

thereby reduce demand for the available

supply of goods and services.

mt£^

This isn't a good time
to start those construction

projects. We have to
^orry about inflation.

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To fight inflation, the government could also raise personal

income taxes, thus reducing spendable income and the

private demand for goods and services.

Fiscal policy has some disadvantages, though, as an anli-infiation tool. For
one thing, it can take a long lime to get a tax or spending bill through Congress.

Another disadvantage of using government expenditure cuts

to fight inflation is that it can be wasteful to turn spending on

and off depending on whether or not inflation is a concern.

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The changes in monetary policy that

sometimes are needed to reduce inflation

can impose some short-term pain on the

economy. For example, to get rid of very

rapid inflation in the early t980s, the Fed had

to accept a severe recession m 1981-1982.

Congress structured the Federal Reserve System

to shelter it from day-to-day political

pressures, so that the Fed could pursue policies

that promote long-term economic grovrth,

that might be unpopular.

One factor supporting the Fed's independence is
that unlike other government agencies, it does
not depend nn appropriations from Congjess,

The Fed is self -financing; the interest
it earns on the U.S. government

securities it owns provides the income
needed to carry out its duties.

Why do we have to use monetary policy to prevent inflation?

Why can't we prevent inflation directly, by placing limits on

how much wages and prices rise?

Also, price and wage controls are very hard to enforce because both

buyers and sellers (in the case of price controls) and both employers and

workers (in the case of wage controls) may wish to violate them.

I don't care what the governmentN
says. I'm not interested in continuing my]
practice unless I can charge patients j
more that I did tast year. ^^/

17

In addition, changes in prices and wages perform a very

important role in the economy — serving as signals to direct

labor and other resources where they are needed.

direct ^^^^y

Suppose, for example, that there's a shortage

of computer professionals. To eliminate the

shortage, employers would offer higher pay

to attract more people into the field.

But if the employers weren't allowed to

offer higher pay, they wouldn't be
able to get the professionals they need.

So far, you have read about the problems that inflation can cause and about the ways
that the government and the Fed can fight inflation. But how do we measure inflation? |

The government has several measures of inflation.
The best known is the consumer price index |CPi),

which measures the prices of items bought by

consumers in metropolitan areas. Those items cover

a wide range of goods and services — food, clothing,

housing, transportation, recreation, laundry

services and much more.

The CP! has a direct effect on the lives of many

individuals and groups. For example, many employers

ItnW wage increase to how much the CP! goes up.

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"Core inflatfon" measures changes in the general price level

with food and energy prices excluded, and thus provides

a more accurate gauge of continuing price pressures.

Critics also pome out that the CPI is slow to recognize that consumers change their buying patterns

over time. Specifically, consumers start buying less of items with rapid price rises and more of

those Items whose prices have not risen rapidly. For example, during years when oil and gas

prices rise sharply, people find ways to conserve on the use of those items.

The accuracy with which the CPI measures inflation has

a significant effect on the budget of the federal

government. That's because certain benefits, such as

5ocial security, are based on how much the CP! rises.

COST OF LIVING INCREASE (N
SOCIAL SECURITY BENEFITS

Ttie CPI also affects the revenue side of the federal

budget. For example, the personal exemptiori under

the income tax — the amount of tax-free income

per person to which a family is entitled —

increases each year, based on the increase in the CPI.

If the CPI overstates inflation, then the personal
exemption increases too much each year, and the
federal government loses tax revenue as a result.

The increase in ^\

the personal exemption \

this year wrill save j

me a few dollars. /

Whatever its imperfection, the CPI remains the most

commonly used inflation measure. What does the CPI

teil us about how well the United States has managed

to control inflation? In the 1970s and early 1980s, as we

saw earlier, inflation was often very rapid, even

reaching double-digit annual rates, but...

PERCENT CHANGE IN CPI (1970-1982)

16,00%
1 4.00%
12.00% ■
10 00% ■

a 00% ■
6 00% ■
4.00% ■
2.00% ■

0.00% M ii' ' i

T*-^

^>C <^<?^» ^ '^ <^ jS' ;^ £• ^ £'

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"The Story of Inflation" uses everyday lan-
guage and lively illustrations to explain:

how inflation is defined,
what causes inflation,

■ the effects of inflation on
individuals and the economy,

I how inflation is measured, and

I how to prevent inflation.

For more information about

New York Fed education

programs, visit;

www. n e v(/y o rkf ed . o rg/e d u c a t io n

To schedule a tour, go to:

www. newyorkfed.org/aboutthefed/

ny_tours.html

Federal Reserve Bank of New York

Public Affairs Department

33 Liberty Street

NewYork, NY 10045

(212)720-6134

NOT FOR RESALE